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Labuan Bulletin of International Business & Finance 2(1), 2004, 1-8 ISSN 1675-7262

Raj Aggarwal∗
College of Business Administration, Kent State University

Abstract This paper notes that the puzzles in our understanding of the determinants of currency values seem to be persistent. While scholarly activity continues to improve our understanding of currency values, this paper suggests that it may be useful to borrow research strategies from a related field, the growing body of research on equity prices in less than perfectly efficient markets. Such research may be particularly relevant for understanding currency values as increasingly larger numbers of currencies now operate in floating rate regimes. In such regimes, currency values are increasingly determined as asset prices in competitive markets.

1. Introduction This paper examines some persistent puzzles in international finance and economics. These puzzles include deviations from theoretical values observed in spot and forward markets in foreign exchange. Observed currency values persistently deviate from purchasing power and interest rate parities. Other related puzzles include an unexplained large home bias against international portfolio diversification and frequent unexpected crashes and crises in international financial markets. These puzzles are interesting because they have not been eliminated by traders nor explained away satisfactorily by economists – indeed their persistence challenge and intrigue us. It seems that while our current research strategies for solving these persistent puzzles in international finance have yielded valuable insights and continue to advance our understanding of the behavior of exchange rates, these research strategies may be

Corresponding author: Raj Aggarwal, BSA 434, College of Business Administration, Kent State University, Kent, OH 44242, United States. E-mail:

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approaching at least a temporary period of diminishing returns. I would like to suggest that research strategies adapted from financial economics have the potential of making much progress in understanding these persistent puzzles in international finance. In other words, can we learn anything from recent research in equity markets that may be useful in understanding currency values? 2. Persistent Puzzles in International Finance The area of international finance is of growing importance even though it is quite old – indeed many of the instruments of modern international payments have been around for many centuries. While international trade is probably as old as human commerce, in recent decades the importance of international financial mechanisms has grown rapidly along with increasing trade and the advent of ever more powerful computers and telecommunication systems. Indeed, the markets for currencies have a wide range of instruments, are global, operate around the clock, and have trading volumes many multiples of trading volumes in the markets for equity or other assets. However, in spite of their extraordinarily high liquidity and near completeness, currency markets are far from being as efficient or rational as our models expect them to be. Here are a few examples. Purchasing power parity is an elegant concept that, in theory, seems to make perfect sense. After all, what could be more rational than the expectation that exchange rates should reflect differential inflation rates or that similar goods should cost the same in different markets. Not only are there major deviations from these simple principles, but these deviations seem to persist for long periods. Further, if there is reversion to the mean, it seems to be very slow (e.g., Rogoff, 1996; Taylor, 2003). Similarly, our rational economic models expect that comparable investments denominated in different currencies should provide the same rate of return. In other words, interest rate parity leads us to expect that any differences in nominal interest rates should be offset by exchange rate changes to result in net returns that are comparable across currencies. However, while forward rates often reflect such interest rate differences reasonably closely, forward rates are very poor estimates of future exchange rates and have been found to be persistently and predictably biased. Thus, such anomalies in currency values can provide many opportunities for trading profit (Cavaglia et al., 1994, Froot and Thaler, 1990; Isaac and Mel, 2001). Indeed, these anomalous deviations of currency prices from theoretically correct levels, puzzlingly persist even though many currency traders have known about them and regularly generate profits based on these deviations (e.g., Kritzman, 1993 and Perold and Schulman, 1988). Another puzzle involves the persistent home bias in international portfolio investment. Investors do not diversify enough internationally. The great degree to which investors favor their home country has not yet been explained satisfactorily by our profession (e.g., Baxter and Jermann, 1997; Lewis, 1999; Uppal, 2001). Finally, there seems to be persistent excess volatility in international financial markets and we

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seem to be constantly surprised by the many periodic crises in financial and currency markets (e.g., Neal and Weidenmeir, 2002; Kaminsky et al., 1998). 1 The persistence of these puzzles indicates that many of our basic assumptions and theories in international finance, while certainly elegant and rational, do not stand up too well to the harsh light of empirical examination. While this makes for an uncomfortable situation that is quite distressing to many in our profession, it makes international finance a challenging and interesting field for study. These anomalies are especially important since these basic foreign exchange theories are the foundations for many other theories in international economics and finance. While we continue to make incremental progress in explaining these and other puzzles using ever newer and more powerful econometric techniques and research designs, we are nowhere close to solving these puzzles. Indeed, sometimes it seems as if our efforts mimic the Herculean Ptolemaic attempts to explain the movements of the stars and planets in the sky without giving up the notion that all heavenly bodies revolve around the earth. Are we international economists also sticking too long to an outdated paradigm? Currency values are increasingly behaving like assets traded in competitive markets. There has been a gradual shift of ever more currency regimes to floating rate regimes especially as fixed rate regimes are becoming harder to maintain. In most of these floating rate regimes, currencies are tradable assets whose values are determined by the balance between supply and demand for that currency. Thus, it is contended here that it would be useful to examine currency values as asset prices that are set by traders reflecting the market forces of supply and demand. However, it may be useful to examine if we should continue to assume that currency markets are perfectly efficient as is mostly done currently in research on currencies. The next section examines the foundations of our belief in efficient markets – one of the bases of our elegant theories of exchange rate determination. 3. Assumptions of the Efficient Markets Paradigm The assumptions underlying our dominant paradigms explaining financial and economic market behavior seem to rest on three major pillars. i. Trading costs and frictions are negligible. ii. Arbitrage and negative feedbacks in market mechanisms lead to equilibrium; and iii. Market participants behave rationally. While each of these assumptions may be reasonable in many situations, it seems more likely that all three assumptions often cannot and do not hold completely. Further, it seems likely that a deviation from any of one of these assumptions may reinforce other deviations so that the compounded effect may be large deviations from our elegant efficient market theories (Ackerlof and Yellen, 1985). In fact, there are good reasons to suspect that the deviations from our assumptions are not only significant in many situations, but also matter a great deal in practice.

While these are important related puzzles in international finance, this paper will focus on currency values.

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Indeed, recent work in financial markets and asset pricing has begun both to acknowledge the impact of significant deviations from these assumptions which underlie efficient markets and to utilize the impact of these deviations in explaining anomalous behavior in the prices of equities and other assets. In fact, there are now a number of books that summarize this new literature on asset pricing, literature that emphasize less than efficient markets (e.g., Lo and MacKinlay, 1999; Shleifer, 2000). Surprisingly, the literature on currency markets and foreign exchange reflects such developments only very sparsely. It is likely that currency markets share limitations similar to those faced by markets for equities and other assets. It is possible that some of the persistent puzzles in international finance and economics mentioned earlier can be explained at least partially if we accept that currency values are determined in markets that are less than perfectly efficient. What are some of the more important characteristics of recent research on equity prices in less than perfectly efficient markets? 4. Equity Pricing in Less Than Perfectly Efficient Markets A number of deviations from efficient markets have been documented in equity markets. For example, there are many calendar (temporal) regularities in returns, and equity returns have also been found to depend on size, market to book ratios, and other firm characteristics (e.g., Fama, 1991). Returns are not normally distributed with significant asymmetry in returns and extreme values of returns more common than expected and some evidence that these higher moments are priced (Aggarwal and Aggarwal, 1993; Christy-David and Chaudhry, 2001). Also, winners sell too early and losers hold on too long and there is documented herding behavior among investors and analysts (e.g., Shefrin and Statman, 1985; Avery and Zemesky, 1998; Odean, 1998). Clearly, equity markets are less than perfectly efficient. A number of reasons for these deviations from efficiency have been investigated and documented. First, trading costs and frictions are not negligible. The largest trading cost seems to be information costs – costs of acquiring and analyzing information necessary for assessing the risks and returns (value) of a traded asset. Risk and uncertainty may be particularly difficult to assess and expectations may often be very fragile. There is much information asymmetry and many incentives for not sharing valuable information (e.g., Ackerlof, 1970). One very important aspect of trading frictions is that arbitrage, a function vital for market efficiency, is demonstrably limited in practice by the need and cost of capital, information availability and costs, and risk appetite (e.g., Shleifer and Vishny, 1997; Abreu and Brunnermeier, 2002; Mitchell et al., 2002). Another important aspect of trading frictions is that bankruptcy costs are non-trivial (e.g., Branch, 2002; Claessens et al., 2003). Since the risk of ruin is not only non-linear but also non-zero in practice, unlike the situation in efficient and perfect markets, in practice unsystematic and idiosyncratic risks are priced. Also, as the classical economist Edgeworth would have no doubt recognized, taxes and accounting treatment may differ according to the type and timing of transactions, creating other frictions.

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Second, market equilibrium needs negative feedbacks between demand and price. In practice, partially due to costly information, there are often significant deviations from market equilibrium with path dependence in prices due to the many types of positive feedback trading (e.g., Arthur, 1996; Aggarwal, 1996; Cohen and Shin, 2002; DeLong et al., 1990). One aspect of a positive feedback effect, that is particularly important as a deviation from market efficiency, is herding behavior among traders, fund managers, and analysts (e.g., Avery and Zemesky, 1998; Chang et al., 2000; Hirshleifer and Teoh, 2003; Kim and Pantzalis, 2003). Third, unlike the efficient market assumption of rational behavior by economic agents, it has been demonstrated that in practice there are systematic deviations from rationality among market participants with systematic effects on asset prices. There are a number of reasons for these deviations from rationality, deviations that lead to lack of rationality in forecasts and significant market inefficiencies (e.g., Aggarwal et al., 1995; Conlisk, 1996; Hirshleifer, 2001). Instead of the theoretical assumption of perfect rationality and complete information, in practice investors make investment decisions under uncertainty and risk, limited by bounded rationality, and with systematic behavioral and psychological biases (Arrow, 1982; Daniel et al., 2002). Examples of systematic behavioral biases in investor decisions include framing, mental accounting, a history of past losses or gains, round number prices, and other non-rational behavior (Tversky and Kahneman, 1986; Machina, 1987; Rabin and Thaler, 2001; DeCuester et al., 1998). Research in the psychology of decision-making has documented the systematic nature of these biases. Further, financial research has documented that these systematic non-rational influences on investor behavior lead to significant deviations from efficient market prices. As this very brief review of recent equity markets research indicates, the three important assumptions about efficient markets listed earlier are violated systematically and significantly in practice. The literature on pricing in the equity markets has been methodically assessing the impact of these violations and relating them to deviations from efficient market prices. We need to do the same in currency research. While economics provides intellectual roots, perhaps due to the richness of the data in financial markets, equity market research has made great strides in understanding the determinants of asset prices – advances that may now provide useful insights in other areas of economics such as international finance. Indeed, it is clear that exchange rates are prices of tradable assets especially as increasing numbers of exchange rates belong to floating rate regimes. However, even though floating exchange rate regimes are becoming very popular and currency values are increasingly determined in competitive markets, research on currency values does not seem to adequately reflect a focus on market mechanisms and does not build adequately on the insights developed in the study of the markets for equities and other financial assets. As this very brief review has indicated, the literature on equity pricing in less than perfectly efficient markets is quite large and may be able to provide useful ideas for understanding currency values. Of course, in applying ideas from equity market research to research on currency values, it may be useful to account for additional sources of trading frictions associated with cross-border transactions including international differences in legal, social, cultural, and institutional structures (e.g., Granovetter, 1985; Eun and

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Janakiramanan, 1986; LaPorta et al., 1998; Foerster and Karolyi, 1999; DeSoto, 2000; Khanna and Palepu, 2000). In addition, currency markets are often influenced by national governments that are unlikely to exhibit profit maximizing behavior when intervening in currency markets (e.g., Sarno and Taylor, 2002).Cross-border inefficiencies can indeed be large – Mancur Olson, a noted sociologist turned economist, titled one of his papers, “Big Bills Left on the Sidewalk” (Olson, 1996). 5. Conclusions It is contended here that it would be useful to treat currency values as prices in less than perfectly efficient markets. While this is starting to happen, this process is still in its infancy and there is still much opportunity (e.g., Evans and Lyons, 2004; Lyons, 2001). By drawing from the work on equity markets, new research on currency prices is likely to contribute fresh insights regarding the puzzles in international finance noted earlier – puzzles that seem to have persisted in spite of profitable trading activity and our attempts to develop satisfactory explanations. It seems that when it concerns currency values, there is much opportunity for commercial and intellectual profit. Acknowledgements An earlier version of this paper was the Edgeworth Lecture sponsored by the Central Bank of Ireland for the 2004 annual meetings of the Irish Economic Association. I am grateful to the organizers of that conference, and to Vinit Jagdish, Feng Jiao, Philip Lane, Brian Lucey, Mike Merriman, Min Qi, John Sheehan, and John Thornton for useful comments but I remain responsible for the contents (including any errors). References
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